Consumer Surplus
Consumer surplus, following Dupuit and Marshall, is a monetary measure of the benefits
to consumers from being able to buy what they want at the going price. It is used to
evaluate the gains from policy changes: Cost-Benefit Analysis recognizes that much of
the benefit may accrue in the form of surplus and so is not measured in actual market
transactions. Consumer surplus is traditionally depicted as the area below the (ordinary,
or Marshallian) demand curve and above the horizontal line representing price.
To illustrate, suppose that there are 10 individuals, whose individual reservation
values (maximum willingness to pay) range from $10 down to $1 in one dollar
decrements. All consumers with reservation values above the market price buy, and each
buyer enjoys a surplus equal to her reservation value minus the amount paid. So, if the
market price is $6.50, four consumers buy, with surpluses ranging from $0.50 to $3.50,
for a total (aggregate) consumer surplus of $8. This consumer surplus equals the gross
benefit ($34 in the above example) minus consumer expenditures. A drop in price to
$5.50 raises consumer surplus to $12.50: $1 extra accrues to each previous consumer
directly from the price reduction, and one more consumer (who then enjoys $0.50
surplus) is induced to buy.
The same idea applies to a consumer buying several units of a good (or when
many consumers each buy several units). Suppose the demand system above represents
the valuations of a single consumer for successive units purchased: the consumer will buy
until the value of another unit falls below the price charged. At a price of $6.50 she buys
4 units and enjoys $8 in surplus. A price drop to $5.50 will induce her to buy more. Her
surplus gain is $4.50, (more than the $4 saved on the previous 4 units). While the
marginal unit purchased is valued at the price, all other (infra-marginal) units provide
surplus. Total consumer surplus aggregates these gains over all units purchased by all
buyers.
The simple procedure described above gives the exact measure of the true benefit
to consumers only under certain restrictive conditions. If there are “wealth effects,” the
consumer’s willingness-to-pay for the marginal unit changes with the amount paid for the
previous units. There is, thus, not just one measure of surplus change, but many. Most
prominently are the Equivalent Variation (the additional money needed to make the
consumer just as well off as the price change) and the Compensating Variation (the
money that could be taken away after the price change to leave the consumer as well off
as before). The consumer surplus change is bracketed between the Equivalent and
Compensating Variations. Fortunately, for small changes or when the good in question
attracts a small fraction of expenditure, it has been shown that these three measures give
similar results.
Consumer surplus counts $1 in surplus the same irrespective of how deserving the
recipient might be. Critics argue that it overemphasizes the preferences of the wealthy,
insofar as they have greater willingness-to-pay. Defenders of consumer surplus argue that
it is a useful in measuring economic efficiency, while redistribution issues should be
addressed separately.